"What is your business model" is often an puzzling question for first time entrepreneurs. It doesn't have to be.
August 22, 2021
Often entrepreneurs get dumbstruck when asked to describe their business model. They might start with a software startup idea and consider how everybody would want to use it. Still, they don’t feel that while value proposition to the customer is the beginning, it must be followed up with a business model that would sustain the company. In this piece, we’ll explain what is a business model, give some examples of a business model, and help you structure it all for investors in your pitch deck.
What is a business model?
Before we talk about business models, let’s look start with a different term: monetization.
“the act or process of earning money from something, especially a business or an asset.”
Most entrepreneurs start with an idea, but they are unsure how to monetize it. So, assuming you have a tech startup idea, you need to figure out how to earn money from it, i.e., how do you monetize it. That is the first and most important step in structuring your business model. Thinking deliberately on how to extract money from the value you’re creating.
Thus, when asked, “What is your business model?” you can mentally replace it with “how will your company make money?”. It’s that simple.
The first step in figuring out your business model is to understand what is the underlying revenue model.
The revenue model describes the flow of value and the payment for that value.
Notice that the value proposition canvas model, does not capture this, but only sticks to describing the mapping of value provided to pains and benefits the customer has. The value proposition canvas does not explain how value is served or how the customer pays for it. To create a revenue model, you’ll need to answer these questions.
WHO is using? Who is paying?
Start by mapping the relevant stakeholders by answering “WHO” questions:
Who provides what value? To whom is that value provided?
Who is enjoying the value?
Who is paying?
Answering these will allow you to identify the main entities who participate in the revenue model, primarily:
The user is the entity or person who engages with the product.
In the simplest models, the user is paying for the product. For example, when you go into a restaurant, you pay for food, service, and entertainment. You are the user who enjoys all of the above, and you pay the restaurant. But that is not always the case. The most common example is a social media platform such as TikTok, where users don’t pay to use the platform.
The paying customers
There are many cases where the user will enjoy the product for free, and another entity would pay for value. The most common example is a free access blog with paid ads.
The user is reading the blog and is not paying for this access. The advertiser might send his ad via an ad network and not even be aware that the blog exists, but the advertiser pays for every ad presented in front of the users.
Paying customers who are not users can be advertisers, sponsors, insurers, and more. Most industries would have their own structure of value providers, users, and payors. Think about the US healthcare system, for example (which also has government payors).
What is paid?
What is paid? In most cases, the paying customers will pay with money, but there are cases where entities who enjoy some value will pay by another coin that can provide alternative value.
For example, many medical AI companies partner with hospitals that get access to their system in exchange for data. The data is valuable to the AI company as it allows them to train their models better and monetize them later on with hospitals that don’t own large amounts of data or can’t share it.
Other forms of payments can be barter activities or money equivalents, though the most straightforward form (and the form you should stick to) is money.
What is the payment for?
Is the customer paying for access, usage, display, license, rental, etc.?
In physical products, the customer usually pays to get ownership of the product, rent it or lease it.
In digital products, the customer can pay for access, per result, per seat, per output, per a report, per module.
In IP products, the customer would pay licensing and/or royalties fees, depending on the product. For example, patent royalties for using a patent developed by a competitor.
Of course, the business model can have any combination of the above:
For example, you provide your customers with business intelligence software per seat and module payment. Every output report usage will have fees attached to it before publication.
How is payment made?
There are many ways the paying customer can pay—one-time payment, subscription payment, usage payments, credit payments, etc.
For example, you can usually buy credits used to purchase photos or pay per photo when you buy a stock photo.
How much is paid per transaction?
In some cases, the payment is fixed per the pricing list, but the price paid is more complex in some cases.
Take Google ads, for example.
How much would an advertiser pay per click?
The answer depends on many factors representing the competition level for that click in a bid system.
In some cases, there is a seasonality effect on the pricing, and in others, the price can be affected by purchased volume or customer commitment.
Online installment plans as revenue model case study
Online installment plans are companies that allow consumers to shop for an item and pay for it later with low or no interest. In effect, they provide an alternative product to a credit card. As they provide “free credit,” it begs the question of what is their business model. Let take a couple of them and look at them in more detail.
Klarna business model
Klarna partners with retailers to offer free credits on purchases done by consumers at those retailers.
The credit user is the consumer, but the primary paying customer is the retailers who want to enable its customer to benefit from the value and are willing to pay a fee. The service can start as a free offering that will change to a priced offering due to competitive pressure.
For example, Klarna can offer its services for free to the most prominent retailers such as Walmart, creating competitive pressure on smaller retailers willing to pay the fee to have the service provided to their customers.
Another revenue model is late payments.
In this revenue model, the paying customer is the user. The credit granted to the user is free up to a point. But, if the customer is late with their payments, they are being charged with high interests charges.
Both AfterPay, and Affirm business models follow the same lines.
Once you describe your revenue model, it’s time to detail the actual numbers you plan to charge in the chosen model.
For example, a common pricing strategy for enterprise SaaS software is tiered pricing depending on the features available to the customer, combined with seat pricing.
So you should detail the different tiers, how much you would charge per seat from each, and try to give the rationale behind your thoughts, e.g., capturing SMB’s who won’t pay for the upper tiers but don’t have a lot of support needs. While it might be logical, you should test it out as the reality might be counterintuitive and small businesses will need more support.
Also, be aware that pricing is a complex and delicate combination of science and black magic. You don’t have to get it dialed today. Just consider the options.
Average account size (ACV) and/or lifetime value (LTV)
The size of a deal. Will you charge $100/month/per user or $200K/annually because you only target large organizations?
How much will you get from a customer per period and/or in the lifetime of your relationship with them?
There are three items to consider emphasizing here.
A sanity check between the deal size and the sales and distribution model.
See below for more info on the sales and distribution model and make sure it fits your ACV plans.
Understanding the relationship between the customer acquisition costs (CAC) and the customer lifetime value (LTV)
You want to show that you can return the investment made into acquiring the customer with a strong multiplier (LTV/CAC ratio of 3x is the golden ratio in SaaS).
Understanding how fast you can recover the CAC in terms of cash flow.
Let’s say your cost of customer acquisition is $400 broken like this: $4: cost per click 10%: visitors converted to freemium user 10%: freemium converted to premium. You’ll need to buy 100 clicks (each $4 for a total of $400) to get a single premium user.
Let’s say the user is paying you $20 a month, and you assume they’ll stay for 24 months. The lifetime value is $480. Most VCs would consider this LTV/CAC very poor, but let’s assume you’re in your early stages of commercialization, and you’ll get better. The problem is that you have to pay the $400 today and will only get the $480 over the course of 24 months. You’ll need to finance that time difference. That is why you often witness a heavy discount on annual subscriptions paid today. The company is giving customers a discount in return for earlier cash flow.
Sales and distribution model
You need to answer how you’ll reach your customers, how you’ll sell them, and how you’ll fulfill the purchase.
First, you need to address marketing – how you will create leads and prospects. This can be any combination of:
Traditional marketing (TV ads, radio ads, billboards, print, etc.).
Inbound marketing (content, SEO, etc.).
Outbound marketing using PPC (Google and Facebook ads).
Whatever your choice, make sure you show some data and tests you did: e.g., CPC (cost per click) when posting ads to your target.
Next, you’ll need to discuss you’ll convert prospects into paying customers.
Self-serve via the web
Inside sales and SDR’s
Field sales and account executives
In the last part, you’ll need to explain how you’ll fulfill the order.
Simple SaaS software can be served directly to the customer, but even some SaaS software such as Salesforce can benefits from customizations and adaptations that local contractors usually fulfill. If this is part of your plan, you’ll need to show why they would do that and some discussions that prove you can partner.
In addition, you’ll need to answer what percentage of your sales will be direct and what will be indirect or via the channel.
Traditionally, direct sales are in your control but are considered more costly and harder to scale.
The channel was more scalable and cheaper to maintain.
We are of the thought that this is a fallacy. Few early-stage startups succeed due to the channel, and thus they should focus on direct customer engagement.
Make sure the ACV numbers are compatible with the Sales and distribution model of choice
One of the essential sanity checks is the computability between the deal size and the got to market strategy.
Larger deals tend to have a more complex buying process that requires a lot of support from sales teams. There needs to be a correlation between your deal size and how you intend to make those sales as reflected in your plans.
So, if you’re saying “my ACV is $100K” and my GTM strategy is “self-signups on my website driven by inbound marketing,” you’d be making conflicting claims, or rather you’d make strong claims that require strong evidence.
ACV < 10K and under $50K – inside sales, which can demo the product and answer questions.
ACV < $50K requires an account executive, sometimes filed sales and over a long sales cycle.
For B2B - List of your current customer and pipeline list
Here is your opportunity to shine, as well as address some items in advance before you are being questioned about them.
For example, you wrote your ACV is $50K, but you have three customers with an ACV of $50K, and the rest are much lower. Spell it out to the investor and explain why that is the case and why you believe future customers will all have the higher ACV.
Valid reasons are early customers discount, lack of modules that were caught up, smaller targets before refocusing to larger targets, etc.
For B2C – activities, cohort, and usage metrics
B2C companies need to show how many users they currently have, when and how they were onboarded, and the churn analysis and cohort analysis over time.
Use any metric that can support your story in the short term and/or help build a long-term story. Be very aware of vein metrics if they don’t have business value.
For example, if you have an app that depends on in-app purchases, showing good numbers of users engage, such as ASL (Average Session Length), but with no support for users who make purchases, might weaken your story. The investors would ask themselves – “The users he was able to attract are happy to spend free time but not buy. Is that because he didn’t manage to attract the spending users or simply as the current purchases don’t have enough value to push the users toward them.”
Financial model vs. business model
To answer the question of “What is your business model?” you should provide a short answer or send a short, concise slide or two. Not a full-blown excel file.
A financial model encapsulates all the assumptions you made into your business model and expands on them.
You can’t have a solid financial model without clearly understanding all the points in your business model. Still, it is not an efficient way for you to communicate it to your investors.
It needs to be short, clear, and to the point.
Business model vs. business plan
A business plan is a lengthy document capturing in detail all the aspects of the business such as the target customer, market, market trends, competition, competitive advantage, etc.
A business model is just one chapter of the overall business model. So, when comparing the two, a business plan contains many aspects of the business, one of them being the business model.
A business plan is considered a long document, whereas the primary points of a business model can be captured in one or two short slides.
Cost structure business model canvas
“The Business Model Canvas is a strategic management template used for developing new business models and documenting existing ones. It offers a visual chart with elements describing a firm’s or product’s value proposition, infrastructure, customers, and finances, assisting businesses to align their activities by illustrating potential trade-offs.” (Wikipedia).
Communicating all aspects represented in the business model canvas would be too much information in reply to “what is your business model?”.
In most cases, you shouldn’t use it as a reply.
In addition, it includes the cost structure box, which is essential when considering your business, is standard for most companies in an industry, and thus best left to be suggested by your business.
For example, most software startup ideas such as SaaS companies don’t have high variable costs/cost of sales or increased expenses associated with their inventory or supply chain management.
Still, they have high costs in talent and marketing. Every investor in the industry understands that without needing to spell it out.
Example of a business model slide pitch deck
Targeting startup co-founders and CEOs (customer definition should already be clear at this stage of the presentation).
Marketing: primarily via inbound marketing. Currently, 25 long-form blogs, with organic traffic of 250 unique users per month of the target customers.
Sales: Sales are self-served over the web to the platform.
Pricing: $100/Month per seat with a freemium tier that allows running public projects.
The average customer has two seats, representing an ACV of $2.4K and an LTV of $4.8K (assuming two years of usage).
The example represents our current state and would NOT secure any VC investment, but that would be mostly due to our too small of a market. But we know that and don’t aim for that, but if you have a VC company, you'll need a better slide 😊.
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